Tags: Weak | Sales | Threat | Recovery | Stocks

Weak Sales Pose Threat to Recovery in Stocks

Monday, 09 August 2010 08:26 AM

Weak revenue growth, which corporate America managed to mask in the second quarter by holding costs at unsustainably low levels, stands as the biggest threat to a recovery in U.S. stocks.

Many of the largest U.S. companies sailed past Wall Street's expectations, their profit boosted by last year's brutal cost-cutting campaigns. Companies laid off tens of thousands of workers, sent remaining staffers out on unpaid leave and halted contributions to employee retirement accounts.

Their top-line performance, though, was less stellar.

Shares of blue chip companies, including JPMorgan Chase & Co., General Electric Co. and McDonald's Corp. sold off despite better-than-forecast earnings on investor concern they face weak demand in the quarters ahead.

The drastic moves that protected them through the financial crisis and worst downturn since the Great Depression of the 1930s are not doing anything to spark consumer demand.

"Companies are learning how to make money in this environment, but it's going to be tough to get profit growth from here without sales growth," said Cort Gwon, director of trading strategies and research at FBN Securities in New York.

Largely on the strength of second-quarter results, the Standard & Poor's 500 index is up about 4 percent since July 12, the day Alcoa Inc. kicked off the earnings season with a profit beat. But that recovery is unlikely to continue without a pickup in revenue.

"We need top-line growth to keep the market moving," said Jerome Heppelmann, chief investment officer at Berwyn, Pennsylvania-based Old Mutual Focused Fund.

Earnings momentum is already slowing. Companies in the S&P 500 racked up 58 percent profit growth in the first quarter. That rate fell to 37 percent in the second quarter, based on the 80 percent of the companies in the index that have reported so far.

Wall Street looks for that to slow further, forecasting 25 percent growth in the third quarter and 32 percent in the fourth, according to Thomson Reuters data.

"Without sales (growth), companies won't be replenishing their inventories, nor will they be adding to plant and equipment or (capital expenditures)," said Howard Silverblatt, senior index analyst at Standard & Poor's in New York. "They won't be doing any hiring, and no jobs means no recovery."

Unemployment has remained stubbornly high in the United States. Data released on Friday showed it steady at 9.5 percent for a second straight month. That came despite a sharper-than-expected drop in overall employment and reflected the troubling fact that more chronically unemployed people had given up looking for work.

S&P 500 companies pushed their operating margin rate to 9.7 percent in the second quarter, which, if it ends the reporting season there, would be the highest quarterly rate on record, Silverblatt said.

"And there lies the problem," he wrote in a recent note, as "the reason for the high margin is low sales growth" and low sales means companies won't be adding to expenditures.

AT&T Inc., Kimberly-Clark Corp. and Mattel Inc. were among the firms that credited cost cuts as a factor in their profit growth.

But some of the cost-cutting — the unpaid furloughs, for instance — were temporary measures that companies, including Honeywell International Inc., will not repeat this year. Likewise, FedEx Corp. said it would resume matching its employees' contributions to their 401(k) retirement accounts, starting Jan. 1.

"We're reaching a point where elevated margins will no longer be achievable since companies will have to start cutting prices," said Joseph Battipaglia, market strategist at Stifel Nicolaus in Yardley, Pa. "We've run out of places to cut costs."

S&P 500 companies that have reported second quarter earnings so far beat analysts' average profit forecasts by 10.2 percent. But revenue was less impressive, coming in just 1.25 percent ahead of the Street's expectations.

Analysts look for revenue growth to slow — it is forecast to rise 3.1 percent in the third quarter, well below the second quarter's 10 percent growth rate.

"Companies have cut costs very effectively, but revenue success is becoming rarer," Battipaglia said.

Many of the largest U.S. companies have been hoarding their cash since the start of the financial crisis in late 2008, when short-term debt markets came to a near standstill and left some worried they would be unable to meet payroll and other immediate financial obligations.

That cash pile does give boards other ways of growing per-share profits, even if revenue remains weak.

"The bigger companies have a lot of cash on their balance sheets," said Cleveland Rueckert, an analyst at Birinyi Associates in Stamford, Conn. "If they don't get earnings growth through cost cuts, they'll get it by using their cash for buybacks or raising their dividends."

GE, for instance, last month said it would boost its quarterly payout by 20 percent.

Still, some investors note that companies have little way of sparking overall spending, so in the meantime, their best course of action is to focus on cost control and wait for a stronger recovery to take root.

"Cost-cutting measures will only lead to bigger profits when revenue growth starts to materialize, which I expect will happen in 2011," said Ned Riley, chief executive officer at Boston's Riley Asset Management. "Revenue growth will be slow to develop, but employment growth will clearly re-establish economic growth."

© 2018 Thomson/Reuters. All rights reserved.

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Weak revenue growth, which corporate America managed to mask in the second quarter by holding costs at unsustainably low levels, stands as the biggest threat to a recovery in U.S. stocks. Many of the largest U.S. companies sailed past Wall Street's expectations, their...
Monday, 09 August 2010 08:26 AM
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